Table of Contents
- Product Cost or Variable Costs
- Fixed Costs
- Breakeven Analysis
- Markup and Margin
- Profitability Goals
- Sales Channel Considerations
As a business owner, one of the most difficult questions you will face is how to price your products. All businesses need to cover their costs, but prices are also impacted by where the product is sold, what the competition charges, what consumers consider a fair price, and how much profit the business needs to make. Finding a price that balances all of these considerations can be quite a challenge.
Setting prices too high or too low can be damaging to the health of your business. It’s worth the effort to carefully consider pricing before launching your product, and to understand the impact of possible pricing structures on your business plan. To find the right price you should start by identifying your costs of production, and other costs of doing business. It is important to understand how different costs affect your business, and how they change with sales. From there you can calculate a break-even point and profitability goals, which will give you an idea of the sales volume you need to achieve over time.
The SBA Learning Center offers several modules on pricing including basic pricing considerations and pricing models for business owners. Small Food Business offers an online calculator that enables you to put your recipe into a spreadsheet and automatically calculate product costs and get pricing suggestions.
Here are some important terms and concepts you should understand when setting prices.
Product Costs or Variable Costs
As a food entrepreneur you are converting ingredients into appealing products to offer to the public. You incur direct costs to produce your product such as ingredients, packaging and labels. You also have the cost of direct labor needed to make the product. All costs directly tied to making a unit of product are product costs. Product costs are also termed variable costs because they rise or fall with the volume of product you are producing. All product costs, or variable costs, are directly connected to sales volume.
You may also have some indirect production-related costs that should be included when calculating your variable product costs. Indirect production-related costs, such as the cost of kitchen rental, spoilage allowances, and the cost of shipping to customers, should be included as product costs. By understanding all of your production costs you can calculate a product cost, or variable cost, per unit for your projected volume.
In addition to product costs you also have other business expenses. Fixed costs, sometimes referred to as administrative overhead, are expenses that do not change with sales, at least in the short term. Fixed costs must be paid even if you have no sales at all, and include expenses that you incur separate from production.
Expenses like accounting, phone service, Internet service, website fees, advertising, insurance, and interest are examples of fixed costs. Salaries for employees not directly involved in production, like sales representatives or administrative assistants, would also be considered a fixed cost. Your prices must generate enough revenue to cover your fixed costs of doing business, in addition to the variable costs of producing your product.
Note that, although fixed costs do not change as sales volume increases (at least in the short term), fixed costs per unit do decline. Consider a business with fixed costs of $3000 a month. If that business sells 500 units a month, its fixed cost per unit equals $6. However, if the business sells 1000 units a month, fixed cost per unit drops to $3.
Understanding fixed and variable costs is the first step in determining a breakeven point for your business. The breakeven point is the number of units or sales dollars you need to sell to cover both your fixed and variable costs. The business isn’t earning a profit, but it isn’t losing money either – it is “breaking even.” Every unit you sell beyond the breakeven point will generate a profit; every unit below it generates a loss.
Calculating your breakeven can help you decide if your business plan is practical or if it needs to be adjusted. Breakeven also gives you an idea of how much product you need to sell before the business will be profitable.
The basic formula for calculating a breakeven point is:
Breakeven Point = Total Fixed Costs / (Selling Price Per Unit – Variable Cost Per Unit)
Let’s say you sell burritos at the Farmer’s Market for $5.00 and it costs you $2.00 in variable costs to make each burrito. If your monthly fixed costs are $3000 you have to sell 1000 burritos each month to breakeven.
Breakeven Point in units
1000 units = $3000 Fixed Costs / ($5.00 selling price – $2.00 Variable Costs)
Your breakeven point in dollars is reached when your gross margin (sales minus variable costs) equals total fixed costs. Therefore your fixed costs for the period, plus all variable costs during the period, equal your Breakeven Point in dollars.
If you have monthly fixed costs of $3000, and variable costs of $2000, you have to sell $5000 worth of burritos a month to breakeven.
Breakeven Sales in dollars = Total Fixed Costs + Variable Costs
$5000 sales = $3000 Fixed Costs + $2000 Variable Costs
For more discussion on how to do a break-even analysis for your business see the SBA website. In depth discussions of variable and fixed costs, and breakeven analyses can also be found in accounting textbooks and many business management guides.
Markup and Margin
Markup and margin are important concepts to understand when setting prices. Both markup and margin refer to the difference between the cost of an item and its price. However, they express this amount in different terms:
- Markup is profit expressed as percentage of cost
- Margin is profit expressed as a percentage of sales, or item price
Here are some examples:
|$1.25||$1.00||$.25||.25/1.00 = 25%||.25/1.25 = 20%|
|$1.33||$1.00||$.33||.33/1.00 = 33%||.33/1.33 = 25%|
|$1.50||$1.00||$.50||.50/1.00 = 50%||.50/1.50 = 33%|
|$1.67||$1.00||$.67||.67/1.00 = 67%||.67/1.67 = 40%|
|$2.00||$1.00||$1.00||1.00/1.00 = 100%||1.00/2.00 = 50%|
As you can see, the same item profit yields a different percentage depending on whether it is expressed as a percentage of sales, or a percentage of cost. Businesses often use a markup to generate prices, but they express profit as a percentage of sales, or margin, on their financial statements. Therefore, a business that marks up a product costing $1.00 by 50 percent will sell that product for $1.50 and make $.50 profit on the sale. When expressed as a percent of sales, that $.50 profit yields a 33 percent margin.
Gross margin is the difference between the revenue generated from selling goods or services and the related product costs. On a financial statement, gross margin equals sales minus the cost of goods sold. Gross margin must cover all your other costs of doing business. It is usually expressed as a percentage, and it is an important tool in evaluating operational and pricing efficiency over time.
If you need a gross margin of 50 percent to run your business profitably, you want to be sure that your pricing will yield at least that high a margin percentage. If you use a 50 percent markup on your products you will earn only a 33 percent margin, not enough to run the business profitably. You must markup your products 100 percent to earn a 50 percent margin.
Resources for understanding gross margin and its impact on your business can be found on the SBA website. A discussion of the difference between markup and margin, and pricing in the specialty foods industry can be found at Yummy Yammy. There are also many margin/markup tables and margin/markup calculators available on line to help you understand these concepts.
Net profit margin is the amount left over after all fixed and variable expenses are subtracted from sales revenues. Net profit margin, or net income, is the “bottom line” of the business. Profits can be reinvested in the business and used to buy new equipment, expand operations, and finance market development. Over time the business needs to generate a positive net profit margin in order to support growth and replenish cash.
Average net profit margins vary by industry, for example in 2013 Sageworks, a financial information company, estimated net profit margins for privately owned restaurants at 5.1 percent, while the Food Marketing Institute reported the average bottom line for supermarkets as 1.3 percent. Many manufacturers aim for a net profit margin of 10 percent or greater.
Whatever you determine the right net profit number is for your business, thinking about profitability goals from the outset is a wise business decision.
Sales Channel Considerations
Pricing decisions also have to factor in where you intend to sell your product, what consumers will pay, and what the competition charges. In addition to knowing your costs, knowing your consumer and knowing the competition are important to setting the right price.
Any business that resells your product, such as a distributor, a retailer or a restaurant will add an additional markup onto the cost of the product you sell them. If you intend to sell through these types of outlets you have to build in allowances for their gross margin percentages in your pricing structure. You want to be sure that the final price to the consumer remains competitive no matter where they purchase your product.
Meeting with prospective retail customers is the best way to find out what margin you should factor into your pricing structure for them. Retailer margins vary depending on the department of the store, for example deli margins are generally not the same as produce margins. Retail department margins usually fall somewhere between 20 to 40 percent, but you will find that different retailers work on different percentages.
If you sell through a distributor that then resells to retailers or other accounts you will need to build in an allowance for their margin also. Specialty food distributors often work on a margin of 25 percent. Many start-up food entrepreneurs chose to do distribution themselves rather than work through a wholesaler. If you do your own distribution remember to factor those costs into your pricing.
Additional resources for understanding how pricing works in the specialty food industry can through industry trade associations. Other pricing resources include the website Gredio, which has a useful discussion of pricing in the specialty foods industry and the Vermont Specialty Food Manual.